What Is a Forward Market?
Let me explain what a forward market is: it's an over-the-counter marketplace where you set the price of a financial instrument or asset for delivery at a future date. You'll find forward markets used for trading various instruments, but the term mainly refers to the foreign exchange market. It also covers markets for securities, interest rates, and commodities.
Key Takeaways
- Forward contracts differ from future contracts in that they are customizable in terms of size and length, or maturity term.
- Forward contract pricing is based on interest rate discrepancies.
- The most commonly traded currencies in the forward market are the same as on the spot market: EUR/USD, USD/JPY and GBP/USD.
How A Forward Market Works
You should know that a forward market creates forward contracts. While forward contracts, like futures contracts, can serve for both hedging and speculation, there are key differences. Forward contracts let you customize them to your needs, whereas futures contracts come with standardized sizes and maturities.
Forwards get executed between banks or between a bank and a customer; futures happen on an exchange, which acts as a party to the transaction. The flexibility of forwards makes them particularly attractive in the foreign exchange market.
Pricing
Prices in the forward market are based on interest rates. In the foreign exchange market, the forward price comes from the interest rate differential between the two currencies, applied over the period from the transaction date to the settlement date of the contract. For interest rate forwards, the price relies on the yield curve to maturity.
Foreign Exchange Forwards
In the interbank forward foreign exchange markets, trades are priced and executed as swaps. This means you purchase currency A against currency B for delivery on the spot date at the current spot rate when the transaction happens. At maturity, you sell currency A against currency B at the original spot rate plus or minus the forward points; this price is set when the swap starts.
The interbank market typically trades for straight dates, like a week or a month from the spot date. Three- and six-month maturities are among the most common, while liquidity drops beyond 12 months. Amounts usually start at $25 million and can go into the billions.
As a customer—whether you're a corporation or a financial institution like a hedge fund or mutual fund—you can execute forwards with a bank counterparty either as a swap or an outright transaction. In an outright forward, you buy currency A against currency B for delivery on the maturity date, which can be any business day beyond the spot date. The price is the spot rate plus or minus forward points, but no money changes hands until maturity. Outright forwards often cover odd dates and amounts, and they can be for any size.
Non-Deliverable Forwards
For currencies without a standard forward market, you can trade via a non-deliverable forward. These are executed offshore to avoid trading restrictions, only as swaps, and settled in cash in dollars or euros. The most commonly traded ones include the Chinese renminbi, South Korean won, and Indian rupee.
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